The year 2011 will be the year of decision for underfunded state and local governments with pension and debt problems. The end of federal money from the stimulus package that many cities and states have used to prop up their finances, combined with the outsized cost of meeting their pension promises, will force a growing number of these governments to act.
The immediate reaction for many will be to try to pass the cost onto the federal taxpayers in the form of a bailout, but Congress should strongly resist any such move. While the troubled state and local governments would promise to mend their ways and characterize the bailout as "time to work out the problem," many of them have long histories of fiscal mismanagement and would soon revert to their old bad habits. A federal bailout would have no more long-term effect than taking away a shopaholic's old credit cards while new ones are already in the mail.
As a recent survey of the problem shows, most academic attention has focused on the overall size of the underfunding, with a number of studies using differing methods to decide how large the aggregate deficit is. However, while the aggregate underfunding proves that this is a major problem that must be dealt with before it gets worse, big numbers do little to guide specific cities and states toward a solution. In addition to the level of underfunding, the solution will depend on the government's willingness and ability to either change pension promises for new or existing workers or require them to pay more for those benefits. These are not easy decisions, and none will be popular among the affected workers, who can be expected to use every possible avenue to resist them.
In many areas, past laws or even state constitutions may sharply limit the ability of cities and states to change any of their existing pension promises. Already, three states that have changed the way pension benefits are indexed have been sued by employee unions seeking to overturn the reforms. Local governments can get around these restrictions by filing for bankruptcy under Chapter 9 of the federal bankruptcy code, but currently, states have no such outlet.
In this environment, Congress should consider a way for states to file for bankruptcy or its fiscal equivalent. Of course, there are serious constitutional questions to be addressed, in particular concerning federalism. One recent article makes a convincing case that a bankruptcy process for states would be constitutionally acceptable so long as a state enters into it voluntarily.
Given the current horrible fiscal condition of both Illinois and California and their lack of real progress back toward fiscal responsibility, there is a clear practical need for such a procedure. As the economy continues to experience a very slow recovery, other states are certain to approach the same level of fiscal crisis and will come hat-in-hand for federal tax dollars to pay for the cost of their irresponsibility. One option should be bankruptcy, and Congress should start thinking about that option now.
Such a process should not be part of a deal under which states can also receive a federal bailout. State and local governments made the mess of their finances, and they should have to clean them up. Congress should provide a mechanism to make the process more direct, giving the states the flexibility to address their fiscal problems consistent with federalism and the principles of limited constitutional government.
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